Tuesday, July 26, 2016

How much do lawyers working in solo practice actually earn? (Michael Simkovic)

In 2015, Professor Benjamin Barton of the University of Tennessee estimated for CNN.com, and Business Insider that attorneys working in solo practice earn an average of slightly less than $50,000 per year.  Barton made similar estimates in his book, “Glass Half Full.”  Professor Stephen Diamond of Santa Clara argues that solo incomes are quite a bit higher. (Barton responded in the comments section).

There is little doubt that solo practitioners typically earn substantially less than lawyers working in large Wall Street Law firms.  However, a closer reading of the Internal Revenue Service data on which Barton relies and Census data both suggest that solo practitioner average (mean) annual earnings are likely closer to $100,000.  

 

    I. Average (Mean) Incomes of Lawyers: Census Income Data vs. IRS Schedule C Net Income Data

According to the U.S. Census Bureau’s American Community Survey, average (mean) total personal income for lawyers who are “self employed, not incorporated” (a proxy for those in small legal practice) was around $140,000 in 2012 and 2013.  For those who were self-employed, incorporated (a proxy for those who are owners of larger legal practices) average total personal income was around $180,000 to $190,000.  These average figures include those working part time.  Restricting the sample to those working full-time increases average earnings for “self employed, not incorporated” lawyers to around $160,000 to $165,000 and for the “self-employed, incorporated” lawyers to $185,000 to $200,000.

Barton based his earnings estimates on average “net income” data from the Internal Revenue Services Statistics of Income for Non-farm Sole Proprietorships  for “Legal Services (NAICS Code 5411)”.  This data is based on Schedule C of form 1040, which is used to calculate one of several sources of income on an individual tax return (“Business Income or Loss”). 

Looking at the same IRS schedule-C net-income data for all non-farm sole proprietorships and applying Barton’s reasoning suggests that in 2013, 24 million American small business owners earned an average (mean) income of $12,500.  This is barely above the poverty threshold for a 1 person household, and considerably lower than average (mean) earned income figures for all Americans reported by the U.S. Census’s American Community Survey (around $47,000 including only those who are employed in some capacity, and $22,000 averaging in everyone—children, the retired, and those not in the work force).

 

    A. IRS Schedule C Data Is Biased Downward:

What explains the large discrepancy between low IRS sole proprietor net income data and higher Census earnings data—for lawyers and for everyone else?  There are several problems with IRS sole proprietor data that are likely to lead to dramatic underestimation of individual earnings. 

 

        1. IRS Schedule C Does Not Report Important Sources of Income

First, IRS Schedule C data does not capture all individual earnings.  It captures only one category of earnings—“Business Income and Loss”—and excludes other extremely important sources of earnings—notably Wages and Salaries, which are reported on a separate line on form 1040.

Many schedule C filers are gainfully employed—and indeed, derive most of their income from salaries and wages—but maintain a side business to earn extra income

 

        2. Taxpayers Understate Business Net Income on Schedule C

Second, the IRS has long recognized that small business owners dramatically underreport their revenue and overstate their business expenses to reduce their tax liability.  According to one widely cited IRS estimates, sole proprietors typically understate their net income—the number used by Barton—by 57 percent.   This IRS estimate has been widely cited by the Government Accountability Office and leading scholars of tax compliance such as University of Michigan Economist Joel Slemrod.

Salaried employees in large established businesses with electronic payroll systems cannot evade taxes on their W-2 incomes because their employers report their compensation to the Internal Revenue Service and other government agencies.  Salaried employees also typically have relatively few opportunities to claim business deductions for personal expenses because they do not have sufficient business income to offset those expenses and the IRS is likely to categorize their activities as “hobbies.”

By contrast, sole proprietors do not have to contend with third-party reporting and therefore have ample opportunity for tax evasion.  The problem of small business owner tax evasion has gotten worse over time as the IRS’s enforcement resources have diminished relative to its responsibilities.  Both the probability of detection and the penalties for tax evasion are very low.[1]  IRS SOI data is based on a sample of unaudited returns.

It seems likely that many small practitioners systematically underreport their net income on schedule C.  Lawyers’ sophistication and familiarity with the legal system may suggest that lawyers are relatively well equipped to reduce their tax bills legally, for example by claiming deductions.  In 2013 IRS average business receipts for legal services sole proprietorships was around $116,000.  Deductions and exclusions averaged around $67,000.  There were 70,000 returns for sole proprietors in legal services with no net income that still generated an aggregate of $1.6 billion in revenue.  To the extent that claimed deductions or exclusions really reflect personal consumption or clever tax planning, business receipts may provide a better guide to true income than taxable net income.  

 

      3. IRS Income Measures Exclude Some Income by Design

Third, and relatedly, there are differences  between Income Tax and Census definitions of income that will tend to make Adjusted Gross Income and Taxable Income lower than Census income.  These differences generally reflect tax policy choices to encourage certain activities or reduce the tax liability of certain constituencies. Unlike Census definitions of income, taxable income will exclude or deduct contributions to self-employed retirement plans and some IRA contributions, self-employed health insurance, contributions to medical savings accounts, student loan payments up $2,500 per year (with a phase-out as income increases), tuition and fees up to $4,000 per year, and so on.  IRS definitions of net income change with changes in tax law, and therefore are not consistent over extended periods of time.

 

        4. “Legal Services” Includes Businesses other than Law Firms

Fourth, as noted by Professor Stephen Diamond, “Legal services”(NIACS code 5411) includes not only “Offices of Lawyers (NAICS code 54111)” but also notaries (NAICS code 54112), title searchers, and other law related businesses (NAICS codes 541191 and 541199 ) typically not staffed by lawyers and that are typically less lucrative than legal practice. The IRS has confirmed by email that its data includes these categories.  However, the IRS does not have more granular information that would enable it to determine what fraction of “Legal Services” in its data constitutes “Offices of Lawyers.” [2]

 

    B. Census Data Is Probably Approximately Right:

There are strong reasons to believe that IRS sole proprietor data systematically and dramatically understates individual income.  Are there reasons to believe that Census data systematically overstates individual income for lawyers?  Probably not.

 

        1. Census Data Underestimates Incomes for Highly Educated, High Income Workers

Individuals have no financial reason to overstate or understate their incomes to the Census.  Innocent mistakes can and do happen.[3] Studies that have matched individual social security earnings records to self-reported earnings on the Census suggest that highly educated, high income workers tend to under-report their incomes to the Census.[4]  This may be because they forget about bonuses, or they report their take-home pay rather than their pre-tax income.  The Census also uses imputation and top-coding procedures that reduce average income for those who are highly educated and in high income professions.  (Frank McIntyre and I briefly discussed these issues in the 2013 draft version of The Economic Value of a Law Degree).

 

        2. Census Data Probably Includes Some Practitioners Who are in Small Practice Groups Rather Than Solo Practice

The biggest problem with Census ACS data for solo practitioners is that self-employed lawyers are not perfect estimates for solo practitioners, because “incorporated” and “not incorporated” are not clearly defined.  Even “not incorporated” could include some owners of practices larger than sole proprietorships.  But the other available categories, the number of lawyers in each category for class of worker, and incomes in each category suggests that the self-employed, not incorporated category maps on reasonably well to small practitioners.

 

    II.  After The JD Data Is Early Career and Looks At Medians Rather Than Means

After the JD suggests that median (not mean) income for solo practitioners is around $50,000 to $80,000, and that only around 10 percent of law graduates are solo practitioners.  By contrast, Professor Barton has suggested that a very large proportion of lawyers are in solo practice and described solos as the legal profession’s “middle class.”[5]

After the JD probably identifies solo practitioners well, but there are two important issues to consider.  First, the median income is likely substantially lower than the mean income.  The IRS data used by Barton and the Census data discussed above both refer to mean incomeSecond, After the JD reports on individuals in the first 3 to 12 years after graduation—a relatively early stage in their careers when incomes will be relatively low.  Earnings will likely increase later in their careers, as may the proportion of solo practitioners.

 

    III. Apples to Apples Comparisons within IRS Data Suggest that Even Lawyers who are Solo Practitioners are Doing Relatively Well Financially

Differences across data sources highlight the importance of apples-to-apples comparisons within a single data source and context.  Unfortunately, Barton mixed and matched different data sources, comparing low estimates from IRS data for legal services sole proprietorships to higher estimates from other sources for workers other than lawyers. 

Comparing across sole proprietorship categories using only the (flawed) IRS schedule C data shows that legal services ranks near the top of industries based on average net-income.  In 2013, Legal services trailed offices of doctors, dentists, and securities brokers, but was well ahead of sole proprietorships in most other industries, which accounted for more than 97 percent of sole proprietorships.  This ranking matches Census and BLS earnings data, which shows lawyers typically trailing doctors, but leading most other occupations.

In other words, lawyers remain among the highest paid occupations and legal services appear to be among the most profitable small businesses. 

 

[1] The probability of a tax evader being detected is low.  The IRS audits less than 1% of tax returns and only around 2% to 3% of Schedule C tax filers.  Audits will sometimes fail to uncover tax evasion even when it is present. 

In addition to low probability of detection, the penalties for non-compliance are also typically low.  Filers who the IRS believes have underpaid can typically resolve the matter by paying roughly what they owe.  The IRS will sometimes accept partial payments as settlement and will sometimes impose penalties that are relatively modest (considering the extremely low probability of detecting tax evasion).

Criminal investigations and jail time for tax evasion on income earned legally are virtually non-existent.  In 2013, there were around 145,000,000 annual individual income tax return filings and 24 million flings by sole proprietors—including millions of tax evaders by IRS estimates.  The IRS only investigated around 2,000 legal source tax crimes.  Only around 1,100 of these lead to incarceration.

One unpublished working paper suggests that lawyers may be more tax compliant than most because of reputational concerns.  Others might suggest that lawyers are not optimally situated to underreport revenue because they tend to be paid by check rather than in cash.  Payment by check makes under-reporting more challenging than payment by cash, but still makes underreporting easier than payment by credit card.  Anecdotally, solo practitioners sometimes settle bills through payment in kind.  In To Kill a Mockingbird the fictional country lawyer Atticus Finch accepts farm products as payment from Walter Cunningham.  In more modern, urban, and non-fictional settings, I’ve known lawyers who have accepted high-end furniture, meals at a client’s restaurant or tailoring at a client’s shop, and even a collection of star trek videos (in the days before Netflix).

Legally, payment for services in goods or other services generates taxable income the same as payment in cash, but barter often goes unreported.  And solo practitioners can aggressively claim deductions even when they cannot underreport revenue. 

Changes in tax enforcement and tax compliance over time mean that biases in IRS data will not be consistent across extended time periods.

[2] Within Census data, Offices of Lawyers are the overwhelming majority of the legal services category.  However, the IRS sole proprietorship data may have a different mix—IRS data suggests far more legal services sole proprietorships than several Census studies.  This may be because Census data for establishments generally includes only establishments with Federal Tax Identification Numbers (EINs), but schedule C does not necessarily require an EIN. 

[3] Intentionally providing false information to the Census is in theory punishable by a small fine, although in practice this is virtually never enforced.

[4] Social security records are thought to be useful because they are tied to third party employer reporting on W-2s.  They could overlook non-W-2 wage and salary income, or contain errors.

[5] ABA data suggests that a substantial proportion of individuals with law licenses are solo-practitioners—perhaps around 37 percent as of 2005.  Census data suggests a lower proportion of lawyers are solos—around 20 percent in 2005 and around 15 percent more recently.  (This is lawyers whose class of worker was “employed, not incorporated”).  The ABA may use a broader definition of “lawyer” based on holding a license to practice law or having a (possibly out of date) entry in a registry; Census only includes as lawyers those who classify their occupation as lawyer each year.  Many individuals with law licenses either work primarily in another occupation or are not actively participating in the workforce.  These nominal lawyers may be classified by the ABA as solo practitioners, inflating solo practitioner counts.

 

UPDATE:

July 28, 2016. I asked Professor Barton a series of questions about his use of IRS data.

Aug. 11, 2016. Professor Barton responded, generally conceding that IRS data is problematic.

Aug. 15, 2016.  I replied to Professor Barton.

http://leiterlawschool.typepad.com/leiter/2016/07/how-much-do-lawyers-working-in-solo-practice-actually-earn-michael-simkovic.html

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